After developing products or services that create value, a marketer must then determine how most profitably to capture that value in both volume and margin. The challenge in doing so is that customers value products differently because of different abilities to pay, different preferences, and different intended uses. Moreover, the timing of customers' needs, the speed of their payments, and the level of service and support they require can drive significant differences in the cost to serve them. When a company tries to serve all customers with one price, or a standard markup in the case of distributors and retailers, it is forced to make large tradeoffs between volume and margin — enabling some customers to acquire the product for much less than they would be willing to pay for it, while others are excluded even though the lower price that they would pay is sufficient to cover variable costs and make a positive contribution to profit.
Except for pure commodities, such as ethanol or pork bellies, a single price per unit is rarely the best way to generate revenues. Realizing a company's profit potential created by the differentiation in its features or services requires creating a structure of prices that aligns with the differences in economic value and cost to serve across customer segments. The goal of that structure is to mitigate the tradeoff between winning high prices for low volume and high volume for low prices. The goal is to capture more revenue from sales where value or cost to serve is higher, while accepting lower revenue where necessary to drive still profitable volume.
To illustrate the huge benefits of a well-defined segmented price structure, suppose that a supplier faced five different segments, all willing to pay a different price to get the benefits they sought from a product . Segment 1 with sales potential of 50,000 units is willing to pay $20 for the firm's product. Segment 2 with sales potential of 150,000 units is willing to pay $15, and so on. What price should the firm set? The right answer in principle is whatever price maximizes profit contribution. If you calculate the profit contribution at each of the five prices assuming a variable cost of $5 per unit, the single price that produces the maximum contribution ($2,750) is $10.
EXHIBIT 3-1 The Incremental Contribution from Price Segmentation
However, a single-price strategy clearly leaves excess money on the table for many buyers who are willing to pay more: those willing to pay $20 and $15. These high-end buyers perceive significantly greater value from purchasing this product, relative to other buyers. At the price of $10, they are enjoying a lot of what economists call “consumer surplus.” The firm would be better off if it could capture some of this surplus by charging higher prices to these buyers. The second problem is that the supplier leaves nearly half of the market unsatisfied, even though it could serve those customers at prices above the $5 per unit variable cost.
For industries with high fixed costs, serving those additional customers is often very profitable and, when they constitute large amounts of volume, can be essential for a company's survival. Railroads could not maintain, let alone expand, their costly infrastructures without a segmented price structure. Railroad tariffs are designed to reflect the differences in the value of the goods hauled. Coal and unprocessed grains are carried at a much lower cost per carload than are manufactured goods, resulting in a much lower contribution margin per carload. Still, the large volumes of coal and grain transported enables that low-priced business to make a substantial contribution to a railroad's high fixed cost structure. If railroads were required to charge all shippers the tariff for manufactured goods, they would lose shippers whose commodities would no longer be competitive on a delivered cost basis and so would lose that profit contribution. On the other hand, if railroads had to charge all shippers the tariff currently charged for a carload of unprocessed grain, their systems would reach capacity before they generated enough contribution to cover their fixed costs and become profitable. Freight railroads survive and prosper by leveraging their capacity to serve multiple market segments at value-based prices for each segment.
Even companies that serve only the premium end of a market often find that it is risky to limit themselves to that segment when they could be leveraging some common costs to serve other segments as well. In his book, The Innovator's Dilemma, Clayton Christensen cites numerous examples of companies that failed to meet demand from the lower-performance, lower-margin segment of a market that they dominated. Invariably, someone eventually addressed that need and used it as a base to partially support the fixed costs investments necessary to enter higher margin segments. For years, Xerox owned the high end of the copier market. It lost that dominant position only after companies that had entered at the bottom of the market developed service networks of sufficient size to support the higher-priced equipment bought by customer segments, such as copy, centers that require quick service to minimize downtime.
How many segments with different price points should a supplier serve? To return to our illustration, shows that if the firm were to set two price points serving two general price segments — high-end buyers willing to pay $15 or more, and mid-level buyers willing to pay $8 or more — it could increase profit contribution by 40 percent. But if the supplier could charge separate prices to each of the five market segments, it could increase profit contribution by 80 percent relative to the single price strategy. In principle, more segmentation is always better. In practice, however, the extent of price segmentation is limited by the ability of the seller to enforce it at an acceptable cost.
Segments for pricing are easier to define conceptually than to maintain in practice because customers whom you intend to charge a higher price have an incentive to undermine the structure. They will not freely identify themselves as members of a relatively price-insensitive segment simply to help the seller charge them more, but will try to disguise themselves as customers who qualify for a lower price. Distributors, too, can undermine a segmented pricing strategy by buying the product for delivery to a customer entitled to a lower price but then actually sell to segments that will pay more and pocketing the difference for themselves. This is a huge problem for companies in the European Union because distributors in countries where prices are lower will ship products to one where prices are higher, which often happens simply due to changes in currency values. European law prohibits attempts by national governments to restrict such “parallel trade” even between two European Union countries that have different currencies. Thus, the manufacturer without a segmentation strategy can lose sales in the low-value country due to shortages, while losing margin to competition with “parallel traders” into the high-value countries.
So how can sellers charge different prices to different customers and for different applications? The answer is by creating a segmented price structure that varies not just the price, but also adjusts the offer or the criteria to qualify for it. A segmented price structure is one that causes revenues to vary with differences in the two key elements that drive potential profitability: the economic value that customers receive and the incremental cost to serve them. There are three mechanisms that one can use to maintain such a segmented structure: price-offer configuration, price metrics, and price fences. Each is appropriate for addressing different reasons for the existence of value-based segments.
